Gilt issue details are generally as dull as court notices or the deaths columns, according to Robert Stheeman, chief executive at the UKâs Debt Management Office. When government budgets are in surplus, as they were for much of the 1990s, it is corporate rather than sovereign bond issuance that grabs the headlines.

We donât see our role as fixing the
yield curve â our role is to fund the deficit in a cost-effective way

Robert Stheeman

However, it is amazing how things change, Stheeman says. The collapse in real and nominal UK government bond yields last month shot the executive agency, a division of the UK Treasury that funds the government’s budget deficit, into the news in what has been an unnerving experience for a discreet part of chancellor Gordon Brown’s department.

The yield on 50-year index-linked gilts fell to 0.38% on January 18, prompting pressure on the DMO to issue more bonds to halt the collapse. Amid the turmoil, the agency faced possibly the biggest decision in its seven-year history – should it intervene to stabilise the gilts market or let market forces determine price levels?

Stheeman belongs to the Alan Greenspan school of economic management – markets may behave irrationally but it is not the role of agencies to restore order. Stheeman says the agency considered intervening but decided against it. But that the question arose at all highlights the role of the DMO, caught between serving its Treasury masters and organising an orderly market. If two-way pricing collapses, as it came close to last month, the DMO could be forced to restore order and meet what is predicted to be growing demand for long-dated gilts from pension funds.

The DMO, established in 1998, is responsible for managing the Treasury’s debt programme. Management before that was the responsibility of the Bank of England. The national debt, which in the 18th and early 19th centuries was a result of borrowing to fund the country’s wars, grew from £12m in 1700 to £850m by 1815, the year of Napoleon’s defeat at Waterloo. Today it stands at £448bn (€654bn).

The agency advises on the structure of borrowing, but does not design it. Stheeman describes the DMO as the Treasury’s “eyes and ears to the market”. It is located in the City of London, not Whitehall, and consults with the market on issuance plans.

Stheeman, who spent 16 years at Deutsche Bank before joining the DMO in 2003, says the most important lesson he learnt in his time on the other side of the fence was the value of receiving objective advice from investment banks. “The importance government issuers place on honest and objective advice from the investment banking community impressed me enormously. Now, sitting on the other side, I can see in particular why we need it.”

Underlying its need to be in direct contact with the market, the agency’s goal is to ensure the UK government borrows as cheaply as possible with the least risk.

Stheeman emphasised the DMO’s role was not to “fix” the yield curve, which has been inverted over most of the last seven years with long-dated issues yielding less than shorts. But the agency is interested in ensuring orderly gilts trading, which has gone awry on several days this year. “There has to be a proper marketmaking function and we have to be reasonably comfortable that there is a fair price arising out of the bid-offer process in the market.”

“When there were serious concerns and calls for us to be tapping in January, we weren’t concerned specifically about the yield of 0.38% on the 50-year index-linked gilt. That figure is not directly relevant to us. What concerned us was whether the market was able to function and whether we needed to step in.”

He adds: “In the event we decided we wouldn’t step in and it’s fair to say the market is on a better footing since. It does not mean we are complacent but we don’t see it as our role to fix the yield curve. Our role is to fund the deficit in a cost-effective way,” says Stheeman.

Before 1995, when debt management was run by the Bank, it could supply gilts on tap, or issue supply when needed as well as conducting auctions. Some say this flexibility is needed again although the DMO already issues extra tranches of existing gilts.

After this month’s annual meeting with market participants the agency could be about to change how it handles supply. Unprecedented purchases of long-dated and index-linked gilts by pension funds has led to greater demand than the government has been able to supply. Pension funds buy index-linked gilts to hedge their liabilities, although many have been deterred by the fall in yields.

Last month’s auction of £650m of 50-year index-linked gilts at a yield of 0.46% was the lowest auction yield since index-linked gilts were first issued in 1981 – the sale was 1.75 times oversubscribed. The upside for the government is that it can borrow cheaply. The downside for the market is there is no relative value in index-linked gilts as demand pressure has distorted the market.

One solution to the distortions in the index-linked market could be to hold auctions more frequently; last year the agency issued £10.8bn of index-linked bonds in 10 auctions and one syndicated offering.

“Liquidity in the index-linked market tends to improve when auctions occur. That would be a perfectly good argument to increase the frequency of auctions,” says Stheeman.
The UK government has a record borrowing requirement of up to £70bn for 2006/07. Dutch bank ABN Amro forecasts index-linked issuance of £17.5bn, of which £10.5bn is likely to have maturities of 25 years or more.

Alongside more regular auctions, a return to tapping is being discussed by the Treasury and the DMO. The Bank changed to auction-only issuance because tapping was regarded as opportunistic and cost the government money, as it was paying a premium to issue debt. The Debt Management Review in 1995 by the Treasury and the Bank changed the system to a predefined and pre-scheduled auction calendar.

“Before we and the Treasury do anything to change that framework, we have to be 100% convinced that we won’t undermine the principles of predictability and transparency. There has to be a careful balance so as not to undermine confidence in the market,” says Stheeman.
Managing an auction alongside tapping would also be difficult to manage transparently and could lead to greater volatility.

“It strikes us that what was floated could have broader consequences and may compromise the overall transparency and predictability of issuance on which the Treasury and DMO place a great deal of value,” say analysts at Barclays Capital.

Another gilt-edged marketmaker says: “Whatever the DMO does, it will maintain an element of squeeze in the market as it suits its borrowing needs. I wouldn’t expect it to be too proactive to change the system. Although it consults the market, it is clear the DMO is acting for the government.”

Record demand has meant the UK government can borrow cheaply by issuing long-dated debt. The DMO does not quantify the demand it expects for long bonds but uses research analysts’ estimates. Stheeman says: “We would never have embarked on our programme of ultra-long issuance had we not been reasonably confident that there was sustainable demand at the long end. The lower yields go at the long end, the better the economic argument for us to be borrowing at the long end and that’s something we are aware of.”

Market participants have also called on the government to consider using swaps to address demand. France suspended its use of interest rate swaps as they were affecting pricing in the eurozone. The UK, which has a less liquid market, may struggle with the weight of an issuer the size of the government. And although swaps help to match duration in a debt portfolio, they do not fund a deficit.

So, given the UK has no duration target, swaps are unlikely to be adopted. The average duration of the UK’s debt portfolio lengthened to about 13 years last year against 12 years at the end of 2004.